Inflation Today, Deflation Tomorrow – The trap

Longer term US Treasuries again fell Friday night as the bond ‘market of truth’ is sending an increasingly clear picture that it sees trouble ahead.  Importantly too, the yield curve is flattening, big time, with the long term 30yr yield crashing to a 4 month low as 2 year bond yields rose.  In other words whilst we might have short term inflation, the market is saying deflation or at least disinflation will prevail and the Fed will crank up the printers again (if it even gets to taper).  Check out the divergence in the chart below:

And hence we get a yield curve flattening with the spread between 5 and 30 year UST yields plummeting to levels not seen since last August after peaking in March, mapping almost exactly the period of gold price declines from August to March.

As the Fed starts “talking about talking about” tapering its easy money policy the bond market is already starting to price in their need to step in and rescue the ensuing financial crash.  Lance Roberts of Real Investment Advice reminded us on Friday “There have been ZERO times in history when the Fed started a rate hiking campaign that did not lead to a negative outcome…..We suggest this time won’t be any different.” with the following chart as evidence:

“Unfortunately, for the Fed, they are really in a tough spot. As discussed previously, the Fed should be using the $120 billion in monthly QE to start hiking rates to prepare for the next recession slowly. But, instead, they will kick the “policy can” further down the road. The longer they wait, the harder it will be to pull off normalization without risking significant market volatility and reversing the economic recovery.”

But the Fed MUST achieve inflation.  The world has its highest ever debt burden and the only way out of that other than default is to deflate it away.  Deflation is devastating and simply not an option. 

Diving into this a little deeper, famed economist Dr Lacy Hunt maps out the current predicament.  Firstly whilst yes the Fed is pumping unprecedented ‘money’ into the system, the existing debt burden is such that this new QE is not finding its way into more debt quick enough.  Its sitting in the banks and at an unprecedented rate as the chart below clearly illustrates.

Likewise, whilst M2, the measure of all this newly created currency, is at all time highs, the all important velocity of money, the number of times one dollar is spent to buy goods and services per unit of time, has never been lower in over 100 years….

As you can see everywhere right now, where this money is causing inflation is in financial assets.  That then has seen US corporates ploughing their capital into financial assets (buybacks etc) rather than productive assets, no doubt contributing to the current supply constraints.  So how does this end?  Lacy warns as follows:

“deflation will win out unless the rules are changed. If the Fed's mandate is altered, as some are now advocating for, to become the "spender of last resort" and able to monetize its liabilities as legal tender, then that would change the game and runaway inflation would ensue.”

Again, as discussed last week that presents a compelling case for gold in either scenario.  This price dip now may merely be the market slow to